The Psychology of Technical Analysis

A chapter-wise review

The Psychology of Technical Analysis

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Table of Contents
Introduction ............................................................................................................................................ 3 Rational Expectations Hypothesis ........................................................................................................... 5 Objective of Technical Analysis ............................................................................................................... 6 Crowd behaviour..................................................................................................................................... 7 Trendlines ............................................................................................................................................... 9 Trend-line break .............................................................................................................................. 9 Head and Shoulders ...................................................................................................................... 10 Multiple top/bottom ..................................................................................................................... 10 The Elliot Wave Principal ...................................................................................................................... 12 Indicators of investor behaviour ........................................................................................................... 14 Volume and Open Interest............................................................................................................ 14 Re-tests ......................................................................................................................................... 14 Momentum ................................................................................................................................... 14 The Advance-Decline Index........................................................................................................... 15

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Introduction
Evolution is the unfolding of order and complexity in the process of learning.

We have discussed various styles of investing, including one based on technical analysis. Technical analysis flies in the face of the efficient-market hypothesis. EMH says that the prices of assets already reflect all past publicly available information. However, by using technical analysis, one is trying to use past data to project future prices, something that wouldnt be possible under EMH. Even if EMH were to be true for individuals, people behave differently when they are in groups. Sometimes a person will be relatively individualistic and at other times the same person will be relatively willing to conform to expectations imposed by others. Individual behaviour is not easily predictable, but group behaviour is. Over the next few posts, I will be reviewing chapters, in sequence, of the book: The Psychology of Technical Analysis. Hope you will join me in the journey towards discovering the secrets of technical analysis!

Arent investors supposed to behave rationally at all times? What is the reason behind seemingly intelligent and rational individuals caving in to heard-instinct? The simple truth is that membership of a crowd causes people to behave differently from the way that they would in isolation. In fact, herd-instinct is hardwired into our brains. Our brain stem (the innermost part of the brain) that is primarily concerned with instinctive behaviour, developed over 250 million years ago, compared to our neo-cortex (which allows us to be aware of the thought process itself and to anticipate the future/recreate the past) that developed only during the last 50 million years or so. The operation of the neo-cortex is all too easily suppressed by the emergence of a crowd mentality. As the crowd comes into being, the brain stem and the limbic system hold sway. Membership of a crowd involves the abrogation of personal responsibility to some degree. A crowd tends to behave in a non-rational way and forces its members to do the same. For most people, some form of crowd pressure provides a major motivating force in their social, economic and political activities. So in essence, a crowd is a self-organized entity defined by a common purpose. Once a crowd is formed, it will react to new pieces of information from the environment. Feedback loops are created and leaders emerge. The feedback loops create stable
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fluctuations (limit cycles) in the relationship between the crowd and the environment. These limit cycles are subjected to shocks and the crowd readjusts to deal with unfamiliar events. Understanding limit cycles and the readjustment process is key to understanding and predicting the the overall behaviour of the crowd.

Related articles Dont Condemn Your Instincts (psychologytoday.com) Flaws of the Brain: Why Certainty Might Not Be as Certain as You Think (healthheralds.wordpress.com) Hidden Flaws in Strategy (ayeshanaveed.wordpress.com) Shiller: More Expectations Theory, Less Efficient Market Hypothesis (ritholtz.com)

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Rational Expectations Hypothesis

A technical analyst knows the price of everything and the value of nothing.

The Rational Expectations Hypothesis is based on three interlinked assumptions: 1. Individuals do not behave irrationally 2. Individuals learn from their mistakes 3. Individuals arrive at their decisions independently of one another However, REH fails in the real world. Natural forces encourage people to herd together as groups. Groups behave as single organisms that respond in predictable ways to new information, have their own emotional cycles and follow a definable path of growth and decay. This is the rationale for technical analysis. Technical analysis assumes that prices reflect the entirety of investors expectations of the fundamentals (both economic and company specific). Financial markets will always be trying to anticipate the future and hence market prices precede changes in fundamental conditions. And most importantly, each price movement is mathematically related to preceding price movements.

Related articles When Does Technical Analysis Work (businessinsider.com) Joe Stiglitz and Joe Gagnon Debate QEII (rortybomb.wordpress.com) The Upside of Irrationality by Dan Ariely (neurosciencemarketing.com)

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Objective of Technical Analysis

When an individual buys or sells securities, an emotional commitment is being made.

The battle between the bulls and the bears is what creates a market for securities. Without the presence of this constant state of conflict, there would be no graduated price movements: prices would jump up and down randomly and no one would trade. When an investor buys/sells securities, he accepts one of the two crowds beliefs about the future trend in prices and identifies strongly with other members of the same crowd (there are exceptions to this, however they form a sophisticated niche). An investor is a committed crowd member. Because of this, as a price trend develops, individual trading decisions become increasingly non-rational. Ultimately, extremes in optimism or pessimism occur, creating the conditions for a reversal. The objectives of technical analysis is to keep a close watch on what other investors are saying and doing and when a vast majority are saying and doing the same thing, do the reverse. The more people who believe in a trend, the fewer people there are left to perpetuate it.

Related articles Choosing Challenge Over Security How Predictability Can End Discovery in Committed Relationships (psychologytoday.com)

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Crowd behaviour
Greed is the fear of missing further profits.

The objective of a crowd in the stock market is to influence prices: the bullish crowd will try to force prices up while the bearish crowd will try to force prices down. The sentiment of the crowd usually turns prior to price reversals. Hence, just before market peaks, sentiment will begin to deteriorate as the percentage increase in price falls. The price-sentiment limit cycle is prone to shocks. Shocks occur because of a sudden divergence between current price movements and expected price movements. Shocks can be either pro-trend or contra-trend. Pro-trend shocks almost always destroy the unsuccessful crowd. However a contra-trend shock will initially cause prices to fall which results in falling sentiment. Eventually, the fall in prices begin to slow and encourages bear closing. This, in turn, causes prices to rise and hence a reversal in sentiment. The disintegration phase of either a bull or bear cycle will occur very quickly. The fear of not making profits is of a different order of magnitude from the fear of actually losing money. This implies that investors prefer to hold stock rather than short positions. The long-bias means that when a bear market begins, not only do very few investors anticipate the fall, but also there is very little resistance to falling prices. Therefore, bear phases take a shorter period of time and are steeper than bull phases. Financial markets exhibit crowd behaviour. A crowd is a dynamic system. A dynamic system can be expressed as a system of spirals. Hence, it follows that if we can identify the presence of an unstable cycle in price movements, we should be able to calculate the precise price targets. The life cycle of a positive shock goes something like this: the initial market reaction that establishes a new trend or the resumption of an old one, a reversal under a spiral mechanism and finally, a jump in a dynamic move. The final jump is 2.618 (the Golden Ratio) times the length of the last wave of the base pattern that precedes it. The actual shape of a price pulse will be distorted by higher-order trends. However, in practice, any price movement subdivides into three phases: the first two phases constitute either a top or base pattern. The third phase consists of a dynamic impulse wave. Subsidiary fluctuations occur because this three-wave pattern is repeated at all levels of the hierarchy.

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Related articles Turning Points (July 2011, 2nd issue) (dowlliott.wordpress.com) The Worry Meter May Overlook Some Warning Signs (nytimes.com) 5 Factors That Drive Stock Prices (money.usnews.com) Nature by Numbers (ritholtz.com) Euclids Ratio (triangulations.wordpress.com)

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Trendlines
There are three categories of price patterns that yield profitable signals.

Trend-line break
This signal is given when the market price level penetrates the extension of a straight line drawn through successive troughs (in a rising market) or successive peaks (in a falling market).

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Head and Shoulders

The H&S formation is similar in shape to a silhouette of a persons head and shoulders. In the case of a top formation, the left shoulder is formed by the period of price weakness just prior to the market moving to a new high; the head is formed by the new high itself; and the right shoulder is formed by a period of price strength just after the new height. The base of both the left and right shoulder occur at roughly the same price levels you can draw a neckline between the two. A sell signal is generated when prices penetrate the neckline.

Multiple top/bottom

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A trading signal is generated when the price bounces away from a particular level at least twice. At market peaks, such a pattern is called the double top. Related articles That Little Itch Should Be Telling You Something (blogs.wsj.com) When Does Technical Analysis Work (businessinsider.com)

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The Elliot Wave Principal

Stock market averages rise in 5 waves and fall in 3 waves

The Elliot Wave Principal (EWP) has a strong following amongst technical traders. However, nobody, including Elliot himself, has been able to explain why it works and remains an extraordinarily complex system to apply. EWP applies to all degrees of price movements. In a 5-3 bull/bear cycle, the first 5 waves themselves are composed of smaller 5-3 bull/bear cycles, etc. So each 5-3 cycle is actually part of a larger, higher-degree cycle.

Indications

The emergence of a 5-wave impulse pattern, either upwards or downwards, indicates the direction of the long-term trend. A rising 5-wave pattern after a sharp fall would indicate further rises, while a falling 5-wave pattern after a sharp rise would indicate further loses. Within each 5-wave movement: Wave 4 will not penetrate below the peak of wave 2. Wave 3 is often the longest, but never the shortest of the 5 waves the constitute the whole movement
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Two of the three waves will be of equal length. Within each 3-wave movement: No ABC formation will ever fully retrace the preceding 5-wave formation of the same degree. Each correction will be at least as large and as long as all lower degree corrections that preceded it. Each correction tends to return to the price range spanned by a corrective wave of one degree lower (i.e., either to wave 2 or 4)

There are some variations that exist Failures and extensions of the 5th wave Diagonal triangles of the 5th wave The three-phase A wave during corrections

Combined with the variations, the EWP covers the complete catalogue of price movements.

Related articles The Big Picture (June 2011 issue) (dowlliott.wordpress.com) wave 2 complete (tradingtrends.wordpress.com) Technical Analysis and Jimi Hendrix (belpointe.com)

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Indicators of investor behaviour

The greatest constraint on taking the right action in any market is doubt.

Volume and Open Interest

Volume is a direct measure of the amount of activity taking place in the market. Open interest is a cumulative measure of the unclosed bull positions in a particular futures market. The level of Volume: The level of volume is indicative of peoples willingness to trade and reflects their attitudes to the market. A low level of volume indicates an unwillingness to open new positions and close old ones and reflects uncertainty about the future direction of the market. On the other hand, a high level of volume indicates a high degree of confidence in the future direction of the market. The level of Open Interest: The level of OI is indicative of the liquidity of the market. if OI is low, then there are very few profits to be taken or bad positions to be closed. At low levels of OI, the market is illiquid and a new trade is likely to move the market. Sudden changes in Volume and Open Interest: A sudden change in volume or OI is indicative of a change in the price-sentiment relationship. Direction of change in Volume and Open Interest: Rising volume suggest a growing awareness of a higher-level trend and rising OI indicates a growing commitment to that trend. Falling volume indicates the unwillingness to pursue the immediate trend and falling OI suggests some reversal of sentiment.

Re-tests
A re-test is considered successful if prices move into new territory. If volume and OI do not rise into high ground, then a non-confirmation takes place and an important trend reversal is about to emerge (doubly true if OI falls as well). If both volume and OI fall as prices move into new territory, then the following price reversal could be quite dramatic. Falling OI, especially with higher volume, portends a sharp reversal in prices.

Momentum
A momentum index is a measure of the speed of change of the market. It can be a 1. simple percentage rate of change, 2. a deviation from a moving average, or 3. the relative strength index (RSI)
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The biggest draw-back of momentum indices is that non-confirmation only generates a signal when prices themselves actually start to reverse.

The Advance-Decline Index

The A/D index is a simple ratio of the number of stocks that have advanced to the number of stocks that have declined. It acts as a proxy for the internal strength of the market. Hence, if a market price index moves into new ground but the A/D doesnt follow suit, then the life expectancy of the movement may be limited and a severe setback may ensue.

Related articles Turning Points (July 2011, 4th issue)(dowlliott.wordpress.com) Pay heed to sentiment in thin-volume August (marketwatch.com)

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